A Management Seminar

© Vanguard Partners 2005 - All rights reserved.Copyright

A Management Seminar

The “Essence” of Value-Based Finance

Presented by:

Roy E. Johnson

Vanguard Partners Ridgefield, Connecticut

2© Vanguard Partners 2005 - All rights reserved.Copyright

Discussion Topics

The “Essence” of Value-Based Finance (VBF) Page/s

– Overview of VBF 3 – 6

– The “Accounting” Model 7 – 13

– Value “Indicators” 14• The “Economic” Model 15 – 17 • Financial “Drivers” 18 – 21

– Value “Analysis” 22• Market Value Added (MVA) 23• The “Magnifier” Effect 24 – 28

– Allocating Resources – Based on “Value Creation” 29 – 31

– Summary 32


“Overview” of Value-Based Finance

(VBF)

“Overview” of Value-Based Finance

(VBF)


Overview

Focused on financial performance, VBF is part of an overall corporate management system that needs to “balance” the value delivered to customers with economic performance.

Therefore, Value-Based Finance (VBF) needs to “fit” within the strategic direction, level of financial sophistication and cultural environment of the corporation.

Value-Based Finance (VBF) is a system to help management deliver value to “shareholders”.


BusinessStrategy

BusinessStrategy

Investment andOperations

Investment andOperations

WorkforceEngagementWorkforce

Engagement

PerformanceMeasurement

PerformanceMeasurement

One way to view VBF is as a sub-system of a larger value-based management (VBM) system, integrating the needs of customers and shareholders.

Overview


Strategy“Evaluation”

Strategy“Evaluation”

“Hardwiring”Strategy to

Budgets

“Hardwiring”Strategy to

Budgets

“Economic”Performance

“Economic”Performance

Financial “Drivers”

Business Analysis

“Alignment” …Managers toShareholders

“Alignment” …Managers toShareholders

“Value-Based” Metrics

Corporate Goals

Overview

Within this framework, VBF coordinates key financial activities.


The “Accounting” Model




“Base Period” CO. ‘A’ CO. ‘B’ CO. ‘C’

Revenue [Sales] $1,000 $1,000 $1,000

Cost of Sales 200 500 800

Gross Profit - $ 800 500 200

- % 80% 50% 20%

Most “accounting” analysis begins with a determination of “Gross Profit”.

This analysis indicates major differences in the relationship of selling price(s) to product cost(s) among the three companies.



Revenue [Sales] $1,000 $1,000 $1,000

Cost of Sales 200 500 800

Gross Profit 800 500 200

Operating Expenses 650 350 50

Operating Profit 150 150 150 Taxes @ 33% 50 50 50

Net Profit - $ $100 $100 $100

- % 10% 10% 10%

Most “accounting” analysis ends with a determination of “Net Profit”.

Factoring in Operating Expenses essentially completes the analysis.




Revenue [Sales] $1,000 $1,000 $1,000

Net Operating Profit [NOP] - $ $100 $100 $100 - % 10% 10% 10%

The Accounting (“Earnings”) model stops here. In this case, all companies are the same ... and, all are “profitable”.

The “accounting” analysis can be summarized as follows:



Correlation of EPS to Market Value

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

Mar

ket

Val

ue

/ In

vest

ed C

apit

al

2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0

EPS Growth

K

RAH

OATMCCRK

SLEHNZ

RAL

CPC

CAG

TYSNA NA

HSY

CPB

GIS

MSTR

R2 = 1%

Source: Credit Suisse/First Boston

The “Accounting” model does not do a good job, however, of explaining “Value”.



Average Market Multiples – S&P Industrials 0.7 1.1 2.1 2.2 4.2

0.9 1.1 1.5 1.5 2.5

1.0 0.9 1.2 1.7 3.2

0.7 0.9 1.2 1.7 3.1

0.7 1.0 1.0 1.4 2.2

0.9 1.1 1.1 1.2 1.6

>-4% -4 to –2% -2 to 2% 2 to 4% >4% Return on Investment “Spread” … ROI less Cost of Capital

RevenueCGR - % >16%

12 to 16%

8 to 12%

4 to 8%

1 to 4%

> 1%

Revenue Growth, ROI Spreads and Market Multiples

Source: Hewitt Associates

…And, revenue growth alone does not create shareholder value. There must be a “return on capital”.



Why?From a financial perspective:

Accounting was not created to do value analysis … rather, its origins are in “credit” and “liquidation” analysis.

A true measure of value creation must factor in “risk” and “return” – which accounting does not do. Thus, two critical elements are missing in the “accounting” model.

Two key concepts that are critical in the understanding of “value creation” for investors will be explored, namely: Economic Profit, and Market Value Added.



Value “Indicators”Value “Indicators”



Revenue [Sales] $1,000 $1,000 $1,000

Net Operating Profit [NOP] - $ $100 $100 $100 - % 10% 10% 10% --------------------------------------------------------------------------------------

Invested Capital [IC] $600 $800 $1,000Cost of Capital [CCAP] 12% 12% 12% --------------------------------------------------------------------------------------

The “Economic Profit” model introduces the concept of Capital required to produce the “Accounting Profit” and the Cost of this capital. We begin to see that all the companies are not the same.

Value “Indicators” – Economic Profit



Revenue [Sales] $1,000 $1,000 $1,000



Economic ProfitNOP [from above] $100 $100 $100Capital Charge [CCAP] (72) (96) (120)Economic Profit [“EP”] $ 28 $ 4 $ (20)



We can restate “EP” as “ROC” by changing the formula within our framework.


Revenue [Sales] $1,000 $1,000 $1,000



Economic ProfitNet Oper. Profit [NOP] $100 $100 $100Invested Capital [IC or C] 600 800 1,000Return on Capital [“ROC”] ~17% ~12% 10%



Growth Rates Invested Capital Intensity Value Profit Margin

These “drivers” provide a foundation for the EconomicProfit and Market Value Added metrics, and give managers a simple, yet powerful, template for value creation.These support measures are also the ones to focus onwhen evaluating business strategies and major investmentprograms.

Value “Indicators” – Financial “Drivers”

There are three major support measures for management focus.


Growth Rates “Relationship” of Revenue, Operating Profit

and Invested Capital Growth .... CGR’s

Invested Capital Intensity How much Capital to Generate One Dollar ($1.00)

of Revenue (Sales) .... in total or incremental .... encompasses working and fixed capital

Value Profit Margin (VPM TM *) Minimum Profit Margin to Create Value for

Shareholders (Owners)


* VPM is a trademark of Vanguard Partners


What is it? A “minimum” profit margin ... in essence, a beginning point

for value creation A pre and/or post tax financial performance benchmark

Why use it? Allows for profitability comparisons for businesses of

different size Simple to calculate and easy to communicate ... especially to

operating managers Provides managers with a threshold ... generating a positive

“spread” creates shareholder value Effective for planning ... strategies, acquisitions, investments ...And, provides an “earnings” measure linked to value.

Value “Indicators” – Financial “Drivers”Value Profit Margin is a very useful support measure.


How is VPM calculated ? Pre Tax Basis -- multiply ‘ICI’ by ‘CCAP’ ...

then, divide by ‘one minus the effective tax rate’

After Tax Basis -- multiply ‘ICI’ by ‘CCAP’

How is VPM calculated ? Pre Tax Basis -- multiply ‘ICI’ by ‘CCAP’ ...

then, divide by ‘one minus the effective tax rate’

After Tax Basis -- multiply ‘ICI’ by ‘CCAP’

Example -- assume Co. ‘A’:

Revenue (Sales) = $1,000, IC = $600 [ICI = $.60] CCAP = 12%, and the effective tax rate = 30%

“VPM” -- Pre Tax Basis.60 x 12% = 7.2% / 70% = 10.3%

“VPM” -- After Tax Basis.60 x 12% = 7.2% ... vs. Actual NOP = 10% (Example)



Value “Analysis”Value “Analysis”


• Economic Profit (‘EP’) translates into Market Value Added (‘MVA’) – closely related to Shareholder Value Creation – through a future financial forecast or outlook. Business strategy should “drive” the assumptions and rationale of a future outlook.

• Assume the following assumptions for the ‘A’, ‘B’, ‘C’ Example:

1. All companies maintain same invested capital to revenue ratio.

2. All companies continue to earn same profit margin on revenue.

3. All companies increase revenue by 10% per year … for 4 years.

The implications of these assumptions and the future outlook’s “value” is dramatic, depending on whether a business is an ‘A’, ‘B’ or ‘C’.

Value “Analysis” – Market Value Added


Company ‘A’Invest capital in growth-oriented

strategies / programs ... with high return potential “Go for Growth” -- instill growth

as a driving force throughout the organization

Emphasize staying close to existing margins and capital intensity, with room for some deterioration if the opportunity is significant

... Growth adds value -- “Bigger is Better” !

Value “Analysis” – the “Magnifier”


% Growth (Sales)

$ “MVA”(Discounted)

20%10% 15%5%

$400

$300

$200

$100

$0

ILLUSTRATION

For Co. “A” -- More growth adds more value !

$256$301

$351

$408

$233

0%

+10%

+MVA %.... (Cumul.) +29%

+51%

+75%



Company ‘B’Earn more operating profit

with the same capital Squeeze additional profit

from existing capital base

.... Selective pricing and/or cost cutting

Emphasize margin improvement

... Growth is secondary -- adds minimal value !



Company ‘C’

Reduce the level of capital employed Streamline / re-engineer / re-structure

operations Validate capital invested in major

lines of business

... Growth ‘destroys’ value !



For Co. “C” -- More growth destroys more value !

% Growth

$ Value - “MVA” (Discounted)

20%

10%

15%

5%

-$300

-$225

-$ 75

-$150

0

ILLUSTRATION

- Sales / Earnings

-$183-$215

-$251-$291

-$167

-10%-29%

-51%-75%



Allocating Resources – Based on “Value Creation”

Allocating Resources – Based on “Value Creation”


The “value-based” approach takes corporate and business unit evaluations to a new level. Assume a hypothetical company with four business units.

“Market” Values$70

$60

$50

$40

$30

$20

$10

-0-

BU #1 BU #2 BU #3 BU #4 Total Co.

‘Total’ Value

‘Strategy’ Value

‘No Growth’ Value

$15$5$20

$5

$15

$20

$5$10$15

$10

$15$5

$35

$35

$70

Per

Sha

re V

alu

es

Allocating Resources based on “Value”

“Strategy” Values can be determined for the Business Units, and should be the basis for making investment decisions.


Market Value / Cash Flow$70

$60

$50

$40

$30

$20

$10

-0-

BU #1BU #2 BU #3 BU #4Total Co.

$15$5$20

$5

$15

$20

$5$10$15

$10

$15$5

$35

$35

$70

Per

Sha

re V

alu

es

Negative Cash Flow Positive Cash Flow

Allocating Resources based on “Value”

When “market values” and “cash flows” are integrated, corporate and business unit analysis is completed.


• Growth “magnifies” value creation (positively or negatively) depending on whether economic returns are above or below the cost of capital.

• Economic Profit translates into Market Value Added through a future outlook, providing a mechanism for valuing strategy and allocating resources.

• The “economic” profit approach and supporting financial “drivers” provide a template to assess progress toward shareholder value goals.

• Operating managers can “drive” value creation by focusing on three key financial indicators:

The relationship of revenue, profit and invested capital growth The amount of capital needed to generate one dollar of revenue Margins (before and/or after tax) above a minimum level required for

value enhancement.

• “Economic” Profit incorporates income statement performance, balance sheet investments and a capital cost, making it more robust than “Accounting” Profit.

Summary: The “Essence” of VBF

• Resource allocation decisions should be based on “strategy value”.

Documents

A Management Seminar